Under United States federal income tax laws, individuals may establish the following four types of accounts from which they can withdraw proceeds to fund their retirement: taxable accounts, deductible tax-deferred accounts, non-deductible tax-deferred accounts, and tax-exempt accounts.
A taxable account, such as a conventional brokerage account, is an account that is funded with after-tax dollars (i.e., income that was previously subject to income tax), and earnings (e.g., interest, capital gains, dividends) are taxed in the year that they are realized at either ordinary income or capital gains rates.
A deductible tax-deferred account, such as a deductible Individual Retirement Account (IRA), 401(k) account or non-qualified deferred compensation account, is an account that is funded with pre-tax dollars (i.e., income that was not previously subject to income tax), and contributions and earnings are taxed, at ordinary income rates, only when they are withdrawn from the account.
A non-deductible tax-deferred account, such as a traditional non-deductible IRA or variable annuity, is an account that is funded with after-tax dollars, but earnings are taxed, at ordinary income rates, only when they are withdrawn from the account.
A tax-exempt account, such as a Roth IRA, is an account that is funded with after-tax dollars, and earnings are never taxed. Thus, a withdrawal from a tax-exempt account is completely tax-free.
The tax basis (“basis”) of an asset is the cost from which gains or losses are calculated for federal income tax purposes. Assets held in a taxable account generally have a basis equal to their purchase price, including any costs associated with purchasing the assets (e.g., brokerage fees). Assets in a non-deductible tax-deferred account have a basis equal to the contributions to the account (on which the account holder has already paid income tax) plus costs associated with purchasing assets in the account (e.g., brokerage fees). Assets held in a deductible tax-deferred account do not have a basis, and the entire amount of funds withdrawn from the account will be taxed as ordinary income. Assets held in a tax-exempt account are withdrawn completely tax free; the concept of basis therefore effectively is not applicable to this type of account (alternatively, the account can be viewed as having a basis equal to its fair market value).
Basis is created in a taxable account each time securities are purchased. Each purchase of securities therefore is said to create a separate “tax lot” that reflects the basis (and holding period) of those securities. For example, if an individual paid $100 to purchase 10 shares of ABC stock in a taxable account and later paid $200 to purchase an additional 10 shares of ABC stock in the same (or another) taxable account, the initial purchase would give rise to a tax lot with a basis of $10 per share and the subsequent purchase would give rise to a tax lot with a basis of $20 per share. Alternatively, if the securities in question were shares of a mutual fund, the individual could elect to take the average cost of all of the shares and create a single tax lot with a basis of $15 per share.
Basis is also created in a non-deductible tax-deferred account each time contributions are made to the account. A non-deductible tax-deferred account, however, is not divided into multiple tax lots. Instead, all of the securities in all of an individual's non-deductible tax-deferred accounts are treated as a single tax lot, and the basis allocated to a distribution from a non-deductible tax-deferred account is equal to (1) the pre-distribution basis to value ratio of the individual's non-deductible tax-deferred accounts in aggregate (i.e., the aggregate basis of all such accounts is divided by the aggregate value of all of such accounts), multiplied by (2) the amount of the distribution. For example, if the individual in the hypothetical immediately above held the ABC stock in more than one non-deductible tax-deferred account (rather than in a taxable account) and sold 4 shares when each share was worth $25, thereby generating a $100 distribution, the basis allocated to that distribution would equal (1) the aggregate basis of all of the ABC stock held by the individual ($300) divided by the aggregate value of that stock ($500) multiplied by (2) the amount of the distribution ($100); thus, the basis allocated to the distribution would be $60.
If the value of a distribution from a non-deductible tax-deferred account exceeds its allocable basis, the difference is taxable as ordinary income. If the value of a distribution from a non-deductible tax-deferred account is less than its basis, the distribution is not taxable but generally does not give rise to a loss. Instead, an individual may claim a loss with respect to a non-deductible tax-deferred account only at the time all such accounts owned by the individual are fully liquidated and only to the extent that the aggregate distributions from all of the accounts over time were less than the aggregate bases of all of the accounts. Any such loss is treated as an ordinary loss that is subject to the 2% floor on miscellaneous itemized deductions.
The concept of multiple tax lots also is not applicable to the deductible tax-deferred account and tax-exempt account.
An individual typically withdraws money from one or more of the four types of account to fund his or her retirement and therefore needs to prioritize among the accounts by creating a withdrawal hierarchy. In some cases, non-tax factors (e.g., the need to maintain an appropriate mix of asset classes such as stocks, bonds and cash) may dictate the account from which the withdrawal should be made. In other cases, however, withdrawing proceeds in the most tax-efficient manner will be the deciding factor.
For some types of accounts, current law requires a minimum withdrawal over the course of a tax year after an individual reaches a certain age. This amount is referred to conventionally and in this document as a “minimum required distribution” (MRD).